Valuations and Trajectories

This week saw Alphabet pass Apple for the title of most valuable company, only to have the situation reverse again later in the week. In the brief period when Alphabet was out in front, I got a lot of calls and emails from reporters asking for comment about the significance of the change in leadership. By the time you read this, that lead may well have changed again and that’s really emblematic of this situation – it’s not as important as the many headlines this week would have you believe.

An entirely symbolic transition

The press loves these transitions because they’re wonderfully symbolic and it gives them hooks to hang much broader-based pieces on companies rising and falling in the public imagination. But symbolism is all that’s really going on here – there is no broader meaning to the valuations of specific companies and specific points in time beyond that symbolism. In fact, it’s arguably entirely coincidental, since investors don’t think in terms of relative total market capitalizations at all, but rather in terms of absolute value for specific companies.

What really matters is trajectory

This is true for any stock, but it’s particularly true for tech stocks: what really matters is trajectory. What I mean is the specific numbers any particular company reports in any given quarter are secondary – what investors care about is how these results look in the context of historic results and what the company is suggesting will happen next. In other words, it’s not so much about where you are now, but the difference between where you’ve been and where you’re heading. If the direction of your company is upward from a revenue and profitability perspective, you’ll garner a much higher valuation than if it’s downward, or flat. Hence, Apple’s record-breaking results were met with indifference, while its March quarter guidance further hit a stock that already had a fair amount of pessimism baked in.

On a long term basis, a company’s valuation should reflect its trajectory and this generally holds true. However, there’s also a fairly significant discount on stocks where the trajectory seems clear but may involve significant risk. Sorry to use Apple as an example again, but it’s the poster child for this phenomenon – Apple’s valuation multiples are much lower than comparable stocks precisely because investors believe (rightly or wrongly) there’s more risk involved in assuming its current trajectory will continue, compared with stocks with seemingly more predictable revenue and profit run rates. This is a big reason for Apple’s recent emphasis on its services business and the power of its installed base – Apple wants investors to see that at least part of its long term trajectory is more predictable than it appears because of its ability to generate additional revenue off the back of its installed base of a billion devices.

On a short term basis, expectations matter enormously too

Although trajectory is arguably the single most important factor in valuations, another important factor in the short term is expectations. Companies’ formal guidance often provide the basis for this but companies that become known for overly conservative guidance may fall victim to over-exuberance on the part of financial analysts. The downside is companies that perform exceptionally well may nonetheless be punished for failing to meet analyst consensus. Amazon and Microsoft’s results last week were a wonderful illustration of this point, especially because they were announced almost simultaneously. On paper, Amazon’s results were stellar – huge year on year growth, improving margins, a growing and increasingly profitable cloud business, and so on – but its stock was hit hard because the results were below what analysts were expecting. By contrast, Microsoft’s results were fairly humdrum, with a number of reasons for pessimism, but analysts cheered them anyway because they weren’t as bad as expected.

Valuations aren’t absolute

Ultimately, the stock market valuations of companies reflect analysts’ assumptions about the trajectories of those companies, their sustainability, and their predictability, rather than an objective measure of the current value of those companies. As such, comparing instantaneous valuations for two stocks and drawing broad conclusions from such comparisons is ridiculous on the face of it. And yet, we see so many overblown pieces about the significance of these transitions, all of which look a little silly the morning after, when the first- and second-place companies have switched places again. Yes, it’s worthwhile to have a conversation about why one company seems to be rising and another falling, but focusing too much on who’s in first place risks missing the point.